Académique Documents
Professionnel Documents
Culture Documents
by
Joseph Whelan
Kamil Msefer
Table of Contents
1. ABSTRACT 4
2. INTRODUCTION 5
3.1 I NTRODUCTION 6
3.2 DEMAND 6
3.3 SUPPLY 8
3.4 I NTERACTION BETWEEN SUPPLY AND DEMAND 9
4.1 I NTRODUCTION 12
4.2 DEMAND 13
4.3 SUPPLY 15
4.4 I NTERACTION BETWEEN SUPPLY AND DEMAND 18
6. SOLUTIONS TO EXERCISES 27
7. APPENDIX 32
1. ABSTRACT
The main purpose of this paper is to discuss supply and demand in the framework
of system dynamics. We first review classical supply and demand. Then we look at how
to model supply and demand using system dynamics. Finally, we present a few exercises
that will improve understanding of supply and demand and help improve system
dynamics modeling skills.
D-4388 5
2. INTRODUCTION
This paper emerged as an attempt to use system dynamics to model supply 1 and
demand. Classical economics presents a relatively static model of the interactions among
price, supply and demand. The supply and demand curves which are used in most
economics textbooks show the dependence of supply and demand on price, but do not
provide adequate information on how equilibrium is reached, or the time scale involved.
Classical economics has been unable to simplify the explanation of the dynamics
involved. Additionally, the effects of excess or inadequate inventory are often not
discussed.
In the real world, the market price is affected by the inventory of goods held by
the manufacturers rather than the rate at which manufacturers are supplying goods. 2 If
the manufacturers are supplying goods at a rate equal to the consumer demand, the static
classical theory would propose that the market is in equilibrium. However, what if there
is a tremendous surplus in the store supply rooms? The manufacturers will lower the
price and/or decrease production to return inventory to a desired level.
This paper introduces a model that incorporates elements from classical
economics as well as several real-world assumptions. This model will be used to
examine some of the interactions among supply, demand and price.
1 Supply and production are very similar terms and are often used interchangeably.
2Low, Gilbert W. (1974). Supply and Demand in a Single-Product Market (Exercise Prepared for the
Economics Workshop of the System Dynamics Conference at Dartmouth College, Summer 1974)
(Department Memorandum No. D-2058). M.I.T., System Dynamics Group.
6 D-4388
3.1 Introduction
This section deals with supply and demand as sometimes taught in high-school
economics classes. The following descriptions of supply and demand assume a perfectly
competitive market, rational consumers, and free entry and exit into the market.
Economists also make the simplification that all factors other than price which affect the
quantity of goods sold and purchased are held constant. Economists argue that this is a
valid assumption because changes in price occur much more quickly than changes in
other factors that may affect supply or demand. Examples of these other factors include
changes in taste, changes in the state of the economy and long-term changes in
production capacity (such as the construction of a new factory).
3.2 Demand
Demand is the rate at which consumers want to buy a product. Economic theory
holds that demand consists of two factors: taste and ability to buy. Taste, which is the
desire for a good, determines the willingness to buy the good at a specific price. Ability
to buy means that to buy a good at specific price, an individual must possess sufficient
wealth or income.
Both factors of demand depend on the market price. When the market price for a
product is high, the demand will be low. When price is low, demand is high. At very
low prices, many consumers will be able to purchase a product. However, people usually
want only so much of a good. Acquiring additional increments of a good or service in
some time period will yield less and less satisfaction.3 As a result, the demand for a
product at low prices is limited by taste and is not infinite even when the price equals
zero. As the price increases, the same amount of money will purchase fewer products.
When the price for a product is very high, the demand will decrease because, while
consumers may wish to purchase a product very much, they are limited by their ability to
buy.
The curve in Figure 1 shows a generalized relationship between the price of a
good and the quantity which consumers are willing to purchase in a given time period.
This is known as a simple demand curve.
3 This behavior toward aquiring additional increments of a good is called diminishing marginal utility.
D-4388 7
Demand Limited by
ability to buy
Price
Demand Limited
by taste
Rate of Purchase
Figure 1: Demand Curve4
This curve shows the rate at which consumers wish to purchase a product at a given
price.
The simple demand curve seems to imply that price is the only factor which
affects demand. Naturally, this is not the case. Recall the assumption made by
economists that the other factors which influence changes in demand act over a much
larger time frame. These factors are assumed to be constant over the time period in
which price causes supply and demand to stabilize.
4 The reader should note that the convention in economic theory is to plot the price on the vertical axis and
the rate of purchase on the horizontal axis.
8 D-4388
3.3 Supply
Willingness and ability to supply goods determine the seller’s actions. At higher
prices, more of the commodity will be available to the buyers. This is because the
suppliers will be able to maintain a profit despite the higher costs of production that may
result from short-term expansion of their capacity 5.
In a real market, when the inventory is less than the desired inventory,
manufacturers will raise both the supply of their product and its price. The short-term
increase in supply causes manufacturing costs to rise, leading to a further increase in
price. The price change in turn increases the desired rate of production. A similar effect
occurs if inventory is too high. Classical economic theory has approximated this
complicated process through the supply curve. The supply curve shown in Figure 2
slopes upward because each additional unit is assumed to be more difficult or expensive
to make than the previous one, and therefore requires a higher price to justify its
production.
Price
Supply
Figure 2: Supply Curve
At high prices, there is more incentive to increase production of a good. This graph
represents the short-term approximation of classical economic theory.
5Short-term expansion can be achieved by giving workers overtime hours, contracting to an outside source,
or increasing the load on current equipment. These types of changes increase per-unit supply costs.
D-4388 9
Demand is defined as the quantity (or amount) of a good or service people are
willing and able to buy at different prices, while supply is defined as how much of a good
or service is offered at each price. How do they interact to control the market?
Buyers and sellers react in opposite ways to a change in price. When price
increases, the willingness and ability of sellers to offer goods will increase, while the
willingness and ability of buyers to purchase goods will decrease. To illustrate more
clearly how the market works, we will look at the following example from the clothing
industry.
Table 1 is called a schedule of demand and supply. For each price, it indicates
how much clothing is demanded by the consumers per week, and how much clothing is
supplied per week. Notice that as price decreases, demand increases and supply
decreases. Eventually demand exceeds supply.
10 D-4388
The market will reach equilibrium when the quantity demanded and the quantity
supplied are equal. At $15, supply and demand are equal at 57 articles of clothing per
week. To better understand the dynamics involved, suppose that one article of clothing
was selling for $30. Producers would be willing to supply 84 articles of clothing per
week, but consumers would only be buying 28 articles per week. As a result, the
producers would have excess inventory piling up very quickly. In order to get their
inventory back to the desired level, the suppliers would have to decrease production and
reduce the price. Eventually, the quantity demanded and quantity supplied meet at 57
articles per week at a price of $15.
D-4388 11
$50
Dem
ply
Sup
and
Price per article of Clothing ($)
$40
$30
Equilibrium Price
Equilibrium
$10
Quantity
$0
0 20 40 60 80 100
Quantity of Clothing per week
Figure 3: Demand and Supply Curves
These curves were plotted from the data for the clothing market included in Table 1.
Figure 3 plots the demand and supply curves from the data in Table 1. Notice that
at $15 the supply and demand curves meet.
12 D-4388
4.1 Introduction
Classical economic theory presents a model of supply and demand that explains
the equilibrium of a single product market. The dynamics involved in reaching this
equilibrium are assumed to be too complicated for the average high-school student.
Economists hold the view that price determines both the supply and the demand.
Equlibrium economics defines only the intersection of the supply and demand curves, not
how that intersection is reached.
On the other hand, system dynamicists believe that the availability of a product,
rather than its rate of production, affects the market price and demand. This means that
the inventory (or backlog) of a product is a major determinant in setting price and
regulating demand. This model is a hybrid of both views in that it introduces the
dynamic effects of inventory into a model that generally replicates the economists’ static
explanation of supply and demand.
To explore the dynamics of supply and demand we will use the clothing market as
an example. Because of a very aggressive marketing campaign, demand for clothes has
increased. How will the suppliers and consumers react?
To study the behavior of the market, we will look at its three major components:
supply, demand, and price. There will be a series of exercises to help you understand the
model. We will first look at consumer demand.
D-4388 13
4.2 Demand
Demand
inventory
shipments
demand
price
Demand in this model obeys one simple rule. It is the demand as dictated by the
demand price schedule. The demand price schedule is a demand curve that indicates
what quantity consumers are willing to buy at a given price. The demand directly affects
two things. First, it determines the outflow to the inventory stock of the suppliers. This
model assumes that the rate of shipments from the inventory is equal to the demand.
Additionally, the demand sets the size of the supplier’s desired inventory.
14 D-4388
Figure 5 shows the simple demand curve used in the demand price schedule
graphical function. This curve is somewhat different from the curve shown in Figure 1.
Because STELLA and system dynamics standard practice require the input to a graphical
function to be on the horizontal axis, it was necessary to reverse the axes. In the curve
shown in Figure 5, price is on the horizontal axis instead of the vertical. As discussed
earlier, the curve shows that consumers are willing to buy more if the price is lower.
4.3 Supply
Below is the supply sector of the model. To simplify the model, we combined the
inventories of all the suppliers into one large inventory. The inflow supply represents the
total production of goods to inventory. The outflow to this stock, shipments, is equal to
the demand.
Supply
Demand
inventory
supply shipments
demand
inventory ratio
price
Before clothes can be stored in the warehouses, they need to be produced. The
supply flow is determined by the supply price schedule. The supply price schedule is a
supply curve which indicates how much the producers are willing to produce for each
price they receive in the market. The source for this relation is the supply curve provided
by classical economic theory6. As with the demand curve, the axes must be reversed so
that price can be an input to the graphical function. The curve used in the supply price
schedule is shown in Figure 7 below.
6 The reader should note that this curve is being used in place of more complictated dynamic structure.
There is no real-world causal relation between the price and the supply rate of a product. The information
contained in the graph is an approximation for the behavior that would be produced by including structure
which includes the effects of varying production capacity and employment.
D-4388 17
increase, it takes larger and larger increases in the market price to justify further increases
in supply.
18 D-4388
Supply
Demand
inventory
supply shipments
demand
inventory ratio
Price
desired price
effect on price
change in price
Price affects supply and demand as determined by the supply price schedule and
the demand price schedule. When price is high, demand is low and supply is high. When
price is low, demand is high and supply is low. We assumed that the only direct action
by a manufacturer to bring inventory to the desired level is to vary price.
The action of the suppliers to regulate the price based on the inventory ratio is
shown in Figure 9. Recall that the inventory ratio is defined as the ratio of inventory to
desired inventory.
D-4388 19
inventory
supply shipments
demand
Inventory Ratio
Price
desired price
effect on price
change in price
At this point, you may wish to build the STELLA model of supply and demand.
The exercises that follow do not require you to run the model, but you may wish to
perform some simulations of your own. The complete model equations are included in
the appendix, beginning on page 33.
You will analyze three scenarios in this section. The first scenario will be a base
case run to observe the response of the model to a step increase in demand. Then you
will analyze how the behavior of the system varies from the base case when you change
the desired inventory coverage and the price change delay. Solutions start on page 28.
#1: What should inventory be in order for the system to be in equilibrium? (Hint: look
at the supply price schedule and the demand price schedule) _______________________
#2: Assume that the system is in equilibrium. Price and inventory remain the same
until the tenth week, at which time there is a permanent increase in demand of 10 units.
(At each price, the consumer demand is 10 articles per week higher.) What are the new
equilibrium values for price and inventory? ____________________________________
22 D-4388
#3: Draw below what you think will happen to inventory in response to an increase in
demand.
1 : invent ory
4 0 0 .0 0
1
2 0 0 .0 0
0 .0 0
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks
We will now explore the response of the system to an increase in demand for
different values of the desired inventory coverage (the number of weeks of desired
inventory coverage). Presently desired inventory coverage is 4 weeks and the system is
in equilibrium. The response of the system to a step increase in demand with desired
inventory coverage = 4 weeks is shown below.
#4: If we change desired inventory coverage to 6 weeks, how would the system react
to the same increase in demand? On the graph below, draw the expected behavior.
#5: Now, draw on the same graph what you expect the behavior of inventory will be if
desired inventory coverage is equal to 2 weeks and there is an increase in demand.
1 : invent ory
4 0 0 .0 0
1
1
1
1
2 0 0 .0 0
0 .0 0
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks
We are now ready to discuss the effect of varying the price change delay. The
delay obviously affects how quickly the price changes, and in the following exercises we
will see how well you can predict the behavior of price when that delay is modified.
#6: Currently, the price change delay is 15 weeks. Assuming everything else remains
unchanged (system in equilibrium), would price or inventory change over time if the
delay is suddenly shortened? __________________
#7: Would you expect the system to reach equilibrium more quickly when the price
change delay is equal to 30 weeks or 15 weeks? ____________
The graph below shows the response of the system to a step increase in demand when the
price change delay is 15 weeks.
#8: If the price change delay is changed to 5 weeks, how would the system react to an
increase in demand? On the graph below, draw the expected behavior of price.
#9: Now, draw on the same graph what you expect the behavior of price to be if price
change delay is changed to 30 weeks and there is an increase in demand.
1 : price
2 0 .0 0
1
1 7 .5 0
1
1
1 5 .0 0 1
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks
6. SOLUTIONS TO EXERCISES
#1: In equilibrium, all stocks must remain constant. The price will remain constant
when the inventory ratio is one. Therefore, in equilibrium, the inventory is equal to the
desired inventory. By looking at the supply and demand curves contained in the
graphical functions of Demand Price Schedule and Supply Price Schedule we can see that
the equilibrium price is $15 when demand and production both equal 57 articles of
clothing per week. Since the desired inventory coverage is 4 weeks, the equilibrium
inventory is 228 articles of clothing.
#2: An increase in demand of 10 articles of clothing per week means that the demand
curve in the demand price schedule is shifted up by 10. An easy way to figure out the
new equilibrium price is to plot the supply curve and the new demand curve on the same
graph and find the intersection. Doing this shows that the new equilibrium price will be
about $17 with production and demand slightly less than 62 articles per week. The new
equilibrium inventory is then 62*4 or 248 articles of clothing.
28 D-4388
1 : invent ory
4 0 0 .0 0
1
1
1
1
2 0 0 .0 0
0 .0 0
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks
#3: The increase in demand causes the desired inventory to immediately shoot up by
40 articles of clothing (10 articles per week * 4 weeks of coverage). At the same time,
inventory begins to drop because shipments are higher than supply. These cause the
inventory ratio to drop, resulting in an increase in price. The price increase causes the
demand to fall and supply to increase allowing the inventory to catch up to the desired
inventory. However, the price continues to rise until the inventory has overshot its
equilibrium value. At this point the inventory ratio becomes positive, causing the price to
begin falling. Although the price is falling, it remains above its equilibrium value
causing the inventory to continue increasing beyond its equilibrium. Eventually, the
price falls below the equilbrium price and causes the inventory to begin decreasing, but
the inventory again overshoots and the system oscillates to its new equilibrium with
inventory equal to about 248. A graph of this behavior is shown in Figure 11.
D-4388 29
#4 & #5: The desired inventory coverage affects the size of the desired inventory.
The response of the system to an increase in demand was very different for the three
values of desired inventory coverage. When the desired inventory coverage was 2
weeks, the inventory seemed to exhibit sustained oscillation. As the coverage was
increased to 4 and 6 weeks, the reaction to an increase in demand was smaller and
stabilized more quickly. This behavior shows that there is a tradeoff when considering
the size of inventory coverage. When the desired inventory coverage is high, inventory
remains fairly stable and is not greatly affected by changes in demand. Unfortunately,
maintaining a large inventory can be costly. Lower values for desired inventory coverage
are less costly to maintain, but react dramatically to changes in demand. Figure 12 shows
the model runs for desired inventory coverage equal to 2, 4 and 6 weeks. (Curves 1, 2
and 3 respectively.)
1 : invent ory 2 : invent ory 3 : invent ory
4 0 0 .0 0
3 3 3
2
2
2
2 0 0 .0 0 2
1 1 1
0 .0 0
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks
#6: The price change delay does not affect the equilibrium state of the model. This
delay only comes into effect when the price is changing. Any change in the price change
delay will not affect the model if it is already in equilibrium.
#7: When the model is knocked out of equilibrium, the price change delay affects
how it approaches its new equilibrium. When the price change delay is short (5 weeks),
the price changes rapidly and overshoots its equilibrium value. The price also converges
on its equilibrium quickly. As the price change delay increases (15 weeks and 30
weeks), the changes are more gradual, the overshoot smaller and the equilibrium takes
longer to reach.
D-4388 31
#8, #9: The graphs below show the reaction of price to an increase in demand when the
price change delay is 5, 15 and 30 weeks.
1: price
20. 00
17. 50
1 1
5 Weeks
1
15. 00 1
0. 00 50. 00 100. 00 150. 00 200. 00
Weeks
1: price
20. 00
1
17. 50
1 15 Weeks
1
15. 00 1
0. 00 50. 00 100. 00 150. 00 200. 00
Weeks
1: price
20. 00
17. 50
30 Weeks
1
1
15. 00 1
0. 00 50. 00 100. 00 150. 00 200. 00
Weeks
7. APPENDIX
demand = demand_price_schedule+step(10,10)
DOCUMENT: This is the rate at which consumers wish to purchase clothing from the
company. The step function is used to jar the system out of equilibrium.
UNITS: shirts per week
demand_price_schedule = GRAPH(price)
(5.00, 100), (10.0, 73.0), (15.0, 57.0), (20.0, 45.0), (25.0, 35.0), (30.0, 28.0), (35.0, 22.0),
(40.0, 18.0), (45.0, 14.0), (50.0, 10.0)
DOCUMENT: This is based on the simple demand curve. At some particular price, the
consumers are willing and able to purchase clothing at a certain rate; the lower the price,
the higher the demand.
UNITS: shirts per week
Price Sector
INFLOWS:
change_in_price = ((desired_price)-price)/price_change_delay
DOCUMENT: Change in price can be either positive or negative depending on
the effect_on_price. If the effect_on_price > 1, then price will increase. If the
effect_on_price < 1, then the price decreases. If effect_on_price = 1, price
remains same. Price changes slowly, so we divide the change by
price_change_delay.
UNITS: price/week or ($/shirt)/week
desired_price = effect_on_price*price
DOCUMENT: This is the equilibrium price as set by the inventory_ratio. The actual
price will reach this value after a delay specified by the price_change_delay.
UNITS: dollars per shirt
price_change_delay = 15
DOCUMENT: Prices do not change instantaneously. This value determines how
quickly price can change.
UNITS : weeks
D-4388 33
effect_on_price = GRAPH(inventory_ratio)
(0.5, 2.00), (0.6, 1.80), (0.7, 1.55), (0.8, 1.35), (0.9, 1.15), (1, 1.00), (1.10, 0.875), (1.20,
0.75), (1.30, 0.65), (1.40, 0.55), (1.50, 0.5)
DOCUMENT: This graphical function regulates price change. When the inventory >
desired_inventory then the inventory_ratio is >1 and price must be reduced. When the
inventory ratio is <1, price must be increased.
UNITS: dimensionless
Supply Sector
INFLOWS:
supply = supply_price_schedule
DOCUMENT: The price supply schedule is based on a classical short-term
supply curve. The company uses this algorithm to set a desirable supply rate for a
given price. This curve is being used in lieu of more complitated dynamic
structure.
UNITS = shirts per week
OUTFLOWS:
shipments = demand
DOCUMENT: This is equal to the demand. The shipments deplete the
inventory.
UNITS: shirts per week
desired_inventory = demand*desired_inventory_coverage
DOCUMENT: Desired inventory is how much inventory the suppliers would like to
have. It is calculated as how many weeks worth of demand they would like to store in
inventory.
UNITS: shirts
desired_inventory_coverage = 4
DOCUMENT: This value sets how many weeks of demand the suppliers would like to
keep in inventory.
UNITS: weeks
inventory_ratio = inventory/desired_inventory
DOCUMENT: This is the ratio of inventory to desired inventory.
UNITS: dimensionless
supply_price_schedule = GRAPH(price)
(0.00, 0.00), (5.00, 0.00), (10.0, 40.0), (15.0, 57.0), (20.0, 68.0), (25.0, 77.0), (30.0, 84.0),
(35.0, 89.0), (40.0, 94.0), (45.0, 97.0), (50.0, 100)
DOCUMENT: This is a short-term supply curve. At higher prices there is more
incentive to produce, more producers can enter the market, etc. This is why this curve
points upward as price increases.
UNITS: shirts per week.
34 D-4388
These graphs represent the behavior of the model set up with the values in the
equations listed above. The model is initialized in equilibrium and there is a step increase
in demand of 10 units/week after 10 weeks.
3 .0 0
2 1
2 1 2
2
1
1
2 0 0 .0 0
1 .5 0
3 3 3
3
0 .0 0
0 .0 0
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks
1 : shipment s 2 : supply
7 0 .0 0
2
1 2
1
2
6 0 .0 0 2 1
5 0 .0 0
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks
D-4388 35
2 0 .0 0
1 2
1 1
2
2
1
1 0 .0 0
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks